February 05, 2010

For over a year now, the financial crisis that pounded world economies in 2008 has been under apparent control. In my view, the TARP and similar measures in other countries did what they were supposed to do, notwithstanding their critics here.

Nevertheless, I’ve been waiting to see whether and when another shoe might drop. Specifically, I’ve worried about the creditworthiness of national governments, including our own. After investors shorted AIG stock and the US government bailed AIG out, investors began shorting the US dollar – signaling that they expected a run on the dollar. This is something I’ve long worried might result from large US deficits. A run on the dollar would be catastrophic for both the US and world economies.

Instead, the dollar rose against other currencies, at least in the short run. Investors worried about the state of the world moved their money to where they believed it safest – US Treasuries. Since then, as investors have regained confidence, the dollar has declined steadily against other major currencies, but not at a rate likely to trigger a run.

We now may be seeing the beginnings of a real sovereign debt crisis. The Greek government has been unable to bring its finances under control; its creditworthiness is in serious question. Spain, Portugal, and Ireland also have immediate debt problems. Portugal is having trouble refinancing its short-term debt. Even the biggest players are not immune. Two months ago, Moody’s declared UK and US debt “resilient,” reserving its highest rating, “resistant,” for French and German government debt. The Bank of England is no longer trying to stimulate the British economy with further UK government debt purchases. President Obama has proposed a selective discretionary spending freeze.

What does all this mean?

If the European economies were not linked through a common currency, the problems of a few less-well-off European governments would probably not be of major concern. After all, we weathered similar problems in Iceland and Hungary without incident in 2008.

But the problems of some Euro Community nations now inevitably affect others. Greece’s problems have triggered a slide in the Euro against the dollar, a renewed flight to the dollar, and a decline in the yield on US Treasuries. Normally, this would trigger a rise in stock values, but the equity markets don’t like what’s going at all, so they’re falling as well.

While fans of the US dollar might be tempted to celebrate any fall in the Euro (the Euro passed the US dollar as the world’s largest currency in October 2009), distrust of sovereign debt is unlikely to bode well for anyone. This growing distrust cannot help but be reinforced by the US Administration’s recent proposed budget, which projects trillion-dollar deficits into the indefinite future. Economist Alan Auerbach projects that within about ten years, US national debt will reach levels that historically have tended to trigger major economic and political shifts. His projections do not necessarily mean we have ten years to solve the problem; rational expectations theory tells us that if we really believe a crisis will hit then, we'll likely precipitate it earlier.

(Grover Norquist is presumably celebrating. He’s the anti-government activist who famously said that he wanted to reduce the US government “to the size where I can drag it into the bathroom and drown it in the bathtub.” He may soon get his way.)

What is the nervous investor to do? Buy German bonds? Maybe. But if Germany remains financially cautious it won’t issue enough bonds to meet world demand. And if the world economy falls into a tailspin, even the finances of the German government are likely to be adversely affected.

The real danger is that investors will go into a “hide it in the mattress” mode. I don’t mean literally. One possible scenario, if investors stop viewing government debt as safe, is world-wide hyperinflation. If the US cannot refinance its short-term debt (an ominously large percentage of its debt is now short-term), it will be forced either to stop operating or to finance its operations by printing money. The former is unlikely to be politically or economically acceptable. The latter may trigger inflation at levels that we’ve never seen –- ever -- in this country.

So the “mattress” has to be real assets – not currency. What assets? Perhaps land (not mortgage-financed) and companies that produce essential goods (food, clothing, shelter) and are not heavily leveraged. Gold was once the safe haven of choice, but Russia has the capacity to produce as much as it needs to finance its spending; if it does so, gold will decline in value as well.

Unfortunately, if investors go into a "hide it in the mattress" mode, the rest of the world economy will be starved for credit, and we’ll be back to yet another -- but much worse -- credit crisis. Only this time, governments will not be able to borrow to bail us out.

Please do not panic. I am not predicting any of the foregoing. I am merely worrying. But I’m now sufficiently worried that I feel it appropriate to worry out loud.

April 21, 2009

The home mortgage interest deduction is probably the single most sacred
provision in the Internal Revenue Code. I remember when, in 1986,
Congress flirted briefly with the idea of repealing it. The secretaries
at my law firm – normally an apolitical bunch – marched through the
halls yelling revolutionary slogans. Congress backed down the next day.

So I’m taking a bit of a risk suggesting that the home mortgage
interest deduction and other tax subsidies for home ownership may be
a bad idea.

First, an important but nonobvious point. Economists agree that home
buyers do not actually receive any net financial benefit from such
subsidies. In the long run, home buyers would be just as well off
financially if the subsidies were eliminated.

What!! How could this possibly be true?

Because home ownership is tax-advantaged, economists tell us that
buyers are forced to pay more for homes than they otherwise would.
Indeed, tax subsidies should cause housing prices to rise to the point
where the new home buyer gets no net subsidy at all. Economists say
that such subsidies are “internalized” in housing prices.

As a practical matter, what this means is that if tax subsidies for
home ownership were eliminated, we’d all pay less for our housing –
substantially less. More affordable homes. Lower home mortgages. Fewer
financial eggs in a single basket. Less risk of financial catastrophe,
either individual or nation-wide.

This, in turn, would mean that the cost of living in cities like Los
Angeles, where I live, would be closer to the cost of living in Des
Moines. Businesses would not have to pay so much to attract employees
to southern California. Families that wanted to sell a home in one town
and buy in another would find it cheaper, easier and less risky to do
so.

There’s more.

Tax subsidies for home ownership (about $190 billion each year) drain
capital from other sectors of the economy – probably substantially more
than the amount of the subsidies themselves. Less capital for
manufacturing, innovation, education – you name it. There is no such
thing as a free lunch. More single-family dwellings necessarily mean
less of everything else. Those who care about underinvestment in
education, infrastructure and the like should therefore also care about
tax-stimulated overinvestment in owner-occupied housing.

Importantly, such subsidies also drain capital out of the rental
housing market. This means fewer apartments at higher rents, creating a
double whammy for low-income Americans. The home mortgage interest
deduction nominally benefits high-bracket taxpayers the most. It
doesn’t benefit low-income taxpayers at all. And by draining capital
from the rental housing market, it increases housing costs for those
who have the hardest time getting by.

Tax subsidies for home ownership thus have a reverse Robin Hood effect,
taking money from the poor and giving it to the better-off. But this
extra money doesn’t actually help the better-off. They need it to pay
the higher prices the market – having internalized those subsidies –
demands for their homes. And then they’re locked in – stuck in
expensive homes with expensive mortgages whenever the housing market
craters, as it does at least once a decade.

But that’s not all.

The fact that our tax system is biased in favor of single-family
dwellings and against apartments means that newer cities like Los
Angeles and Houston, built largely since the income tax was enacted in
the early 20th century, tend to be very spread out.
This means that it takes forever to get anywhere. Because population
densities are lower, mass transit is less viable. Families must
typically own and drive at least two cars. (In Los Angeles, we even
drive to the grocery store. This is not true in most European cities.)
Commuting to work by bus or subway is the exception. Traffic jams are
the norm, even with eight-lane freeways. Rush hour never ends.

And this means dirty air. It is no coincidence that Los Angeles and
Houston, the largest American cities built since the income tax was enacted,
have the worst air pollution – nitrogen oxides, carbon monoxide, carbon
dioxide, particulates, ozone. Over 500,000 Americans die each year from
cardiopulmonary problems. In effect, we’re breathing our own tax
deductions. (Happily, we’re allowed to deduct the resulting medical
expenses.)

Pollution is not the only resulting health problem. The fact that we
drive everywhere means we get less exercise than we would in a
higher-density city. We’re fatter and less fit. We no longer get our
beta endorphins from ordinary living; we have to buy them at the gym.
When we can’t, we seek happiness in less healthy ways. Our kids are
increasingly obese. We drive forever to take them to soccer and then
fret about air quality when they wheeze.

In the process, our carbon footprint grows ever larger. Today’s Los
Angeles contributes far more to global warming than it would if it were
more compactly designed. So we mandate costly additives to our gasoline
to reduce pollution and propose tax incentives for alternative energy
and higher gas taxes to persuade people to stop driving.

I am, of course, exaggerating – to some extent. Our ills have multiple
causes. They are not all the result of Section 163(h)(2)(D) of the
Internal Revenue Code.

But tax provisions intended to enable every American to own a separate
home on a separate lot with a lawn and a garage and a swing in the
front yard are not costless.

At the very least, we should think carefully about what the American
Dream really is. If we’re not clear about what we really want, we’re
unlikely to get it.

February 11, 2009

It is impossible to understand the mess we’re in today (or to develop plausible ways of cleaning up that mess) without taking into account the quarter century of U.S. tax and economic policies that got us here.

Until 1984, the total amount of debt in the American economy – government, business, and consumer – was largely self-regulated. If the government borrowed too much, interest rates rose. Businesses and consumers then borrowed and spent less. And the economy slowed.

As a result, demand played a crucial limiting role in economic policy. Policymakers could not focus solely on the supply side; they also had to be sure that businesses and consumers would have enough money to buy whatever was supplied.

Key to the pre-1984 system was the fact that U.S. borrowing was financed, for the most part, by U.S. savings. The Internal Revenue Code imposed a 30% flat tax – known to international tax junkies as “the tax on portfolio interest” – on U.S.-source interest paid to foreign lenders. Foreign lenders therefore generally did not lend to American borrowers. This, in turn, constrained the total amount of U.S. debt.

In 1981, President Reagan pushed through what was then the largest tax cut in U.S. history. Economists predicted that the resulting deficits would force interest rates up, crowding out business and consumer borrowing.

They were right.

By early 1984, interest rates were moving steadily upwards. As economists had predicted, the clouds of recession were gathering. Polls suggested that Reagan would be a one-term President.

A tax bill happened to be working its way through Congress. Treasury suggested that Congress add a minor technical change to the bill: repeal of the tax on portfolio interest. The reason given? That a few taxpayers were circumventing the tax by taking advantage of a loophole in the Antilles Protocol to the U.S.-Netherlands Tax Treaty. (Amend the Protocol? Heavens, no!)

Clueless, Congress did as Treasury suggested.

The results were as you might predict. Interest rates began to fall the day the House Ways and Means Committee approved the change. No longer limited to domestic savings, U.S. borrowing mushroomed. The economy boomed. And Reagan was reelected in a landslide.

For over two decades, repeal of the tax on portfolio interest effectively eliminated macroeconomic limits on U.S. borrowing. Government deficits produced no apparent adverse consequences – no matter how large. Policymakers found that they no longer had to ask whether consumers could afford any goods and services produced; consumers simply borrowed the amounts needed. Supply-side economics reigned supreme.

On the flip side, foreign demand for U.S. debt proved insatiable. Bad credit? No problem. We’ll give you a zero-down teaser-rate mortgage. We’ll package it with thousands of others and sell the resulting pools to investors round the world. And they’ll buy, buy, buy.

Until this fall, when the whole house of cards came tumbling down.

What happens to an economy built on temporarily unlimited access to consumer credit? When that credit dries up, the inflated levels of demand it supported become unsustainable. Demand must inevitably fall to some lower level – a level supported by real wages.

What is that level today?

Unfortunately, no one knows. We do know that real wages have remained flat for the past eight years. Growth in consumer demand over that period, it appears, was made possible primarily by growth in consumer credit. That credit is now gone.

It is plausible, therefore, that sustainable demand should not be significantly higher than it was eight years ago – in other words, that our economy needs to shrink by about 20% to get back to a sustainable equilibrium.

To date, our economy has contracted only a small fraction of that amount. If 20% is the right number, there is more pain – much, much more pain – to come.

Whatever its size, there is clearly a gap between the inflated level of demand just before the crash and the level of demand sustainable in the long run. It’s this demand gap that’s driving the current downturn as the economy seeks a lower, more realistic equilibrium.

What this means is that the current recession is not an ordinary business cycle downturn. It is rather part of a major structural realignment. Not surprisingly, the vast majority of economists – who first analyzed our current problems using ordinary business cycle models – have been forced to revise their projections downward again and again.

Unfortunately, this kind of downturn feeds on itself. Inadequate demand? Cut jobs. Don’t have a job? Buy less. A downward spiral with no obvious end in sight. Economists call this “deflation.”

What, then, is the solution? If the problem is a demand gap, fill the gap. This is the theory underlying the $800 billion stimulus package working its way through Congress.

$800 billion is about 5% of GDP. Will a 5% plug be big enough to fill the current hole in demand? My back of the envelope calculations suggest that it won’t be. Even if it is, all the package should do is slow the downward spiral. Unless we are willing to run trillion dollar deficits forever, at some point we’re going to have to let demand fall to levels sustainable without government intervention.

All this sounds really depressing. I want to point out, however, that even if our economy contracts by 20% (economists call a 10% contraction a “depression”), it will still generate enough wealth to feed, clothe, house, and provide medical care for all its citizens at levels far higher than Americans enjoyed in the heyday of the 1950’s and 1960’s.

Yes, Congress should try to slow the fall. If I am right, however, a return to sustainable levels of demand is inevitable. Trying to prevent such a return is no more likely to succeed than trying to stop the tide.

What Congress can do is to take steps to ameliorate the resulting pain. Markets can’t. Congress can.

November 26, 2008

Every time I’ve prepared to post an update to my original post on the current financial crisis, events have passed me by. I’ve finally decided to post anyhow.

Mr. Paulson’s original $700 billion proposal addressed the liquidity freeze in two ways. First, by buying up mortgage-related assets at fair market value, Mr. Paulson could take those assets off the financial intermediaries’ balance sheets. The idea was to allow lenders to assess potential borrowers’ creditworthiness with greater confidence and, hopefully, get banks lending to each other again.

Equally importantly, however, Mr. Paulson requested authority to buy up these assets at whatever price he thought best. By buying such assets at higher prices than the market was willing to pay, he hoped to bolster the intermediaries’ balance sheets – to make them more creditworthy.

This aspect of the proposal was what made it a “bail-out.” And this was part of what led to its initial defeat in the House.

It bears emphasizing that the proposal was not intended to solve the teaser-rate mortgage problem, either now or into the future. In the transactions that created the teaser-rate mortgages in the first place, both parties had made bad decisions – the lender and the borrower. Mr. Paulson’s proposal was not intended primarily to help either party.

One of its unavoidable side effects, however, was to relieve lenders of the consequences of their bad decisions, while leaving borrowers to suffer the consequences of theirs. This made it politically less palatable.

After adding a bunch of other stuff, Congress ultimately passed the bill. As ultimately enacted, the bill had three main components.

First, Mr. Paulson received authority to buy up to $700 billion of troubled mortgages or mortgage-related assets. The bill created something called the Trouble Asset Relief Program, now known as the “TARP.”

Second, the bill confirmed that the SEC could (and should) modify the “mark-to-market” accounting rules. Bowing to Congress’s will, the SEC then created an exception to those rules for assets in which there were thin markets. FASB has since followed suit.

Third, Democrats insisted on provisions allowing Mr. Paulson to use TARP assets to purchase equity positions in banks and other financial institutions – in other words, to pump money into such institutions in exchange for partial governmental ownership.

What happened as a result of enactment of the bill? Dominoes stopped falling, at least in the United States, but the stock market tanked. And the LIBOR and TED spread actually went up after the bill passed, not down. Why? Let’s start with mark-to-market.

The Modification of Mark-to-Market

Although it has largely disappeared from press accounts, modification of mark-to-market was the first of the three bailout components to take effect. It had major consequences – one desirable, the rest undesirable.

Recall what mark-to-market required: A company owned an asset purchased originally for $100. The asset had fallen in value to, say, $40. Mark-to-market required that it record a $60 loss and adjust its balance sheets to reflect the resulting lower net worth. The purpose was to give shareholders, creditors, and the company’s board a realistic sense of how the company was doing.

Unfortunately, no one wanted mortgage-related assets. Very few trades were occurring. Those that were took place at fire-sale prices. Financial institutions holding mortgage-related assets came under pressure to mark the value of their mortgage-related assets down to those same fire-sale prices – in other words, to recognize massive losses and adjust their balance sheets to reflect a smaller net worth. This, in turn, threatened to cause more financial institutions to fail, dumping more toxic assets into the market, forcing prices further down – the classic vicious cycle.

Why modify the mark-to-market rules? If companies didn’t have to mark their assets down, they wouldn’t have to recognize the resulting losses and would be less likely to fail.

And it worked. We’ve seen very few dominoes falling since the rule was modified.

But note the problem. If a financial institution holds large amounts of mortgage-related securities that no one wants, it now no longer has to tell its shareholders, creditors, or board the scope of its problems.

Is this a good thing? Well, managers might think so, but investors, creditors and board members might not.

What lenders really want to know is this: If the potential borrower were forced to sell its assets at fire-sale prices, would it still be good for the loan? Today, a lender cannot rely on a borrower’s certified financial statements to answer this question.

Worse, the articulated problem with mark-to-market was solely in the financial sector. But the SEC and FASB both modified mark-to-market generally – for all publicly reporting entities. The result was to make all financial statements less reliable, even those in non-financial sectors.

In retrospect, therefore, it’s not surprising that the LIBOR and TED spread kept going up and the stock market kept going down. In my view, the modified mark-to-market rules are still problematic.

The Proposed Purchase of Mortgages and Mortgage-Related Securities

What about Mr. Paulson’s original idea? His original idea had been to purchase mortgages and mortgage-related securities. He got the authority he wanted from Congress. But he soon discovered that the idea wasn’t going to work.

Why? The problem is that mortgages are not fungible. One teaser-rate mortgage may be worth face because it’s secured by a house that hasn’t gone down in value; another may be worth only cents on the dollar. Mr. Paulson couldn’t just buy all the mortgages held by financial institutions. He only had $700 billion to play with.

So he needed to answer three questions: First, which mortgages to buy? Second, how to value them? Third, how to structure the purchases without forcing the institutions he was trying to save to recognize yet more losses and fail. He realized very quickly that the task was going to take months, not days. And he didn’t have months. LIBOR was still going up, the Dow was down 30%, and the world’s economic engine was freezing up.

Ten days had passed since Congress had enacted the bailout plan, and Mr. Paulson was still just hiring his staff.

The Eurozone Solution

Enter Gordon Brown, Prime Minister of the UK and former Chancellor of the Exchequer. My guess is that a century hence, economic historians will give Mr. Brown credit for having saved the world – at least temporarily.

On Sunday, October 12, 2008, Mr. Brown persuaded the members of the Eurozone to adopt a two-part plan. First, they would guarantee all interbank debt. Second, they would give banks massive capital infusions by buying equity in them.

Mr. Paulson jumped at this solution and announced that the US, too, would follow the Brown plan (although he didn’t call it that). Happily, Congress had given him authority to use TARP funds to purchase equity positions in US financial institutions – over his objection.

That Monday, he announced that Treasury would use $250 billion of his $700 billion to do just that. He and Mr. Bernanke also announced that the US government would guarantee all interbank loans.

And it worked, sort of. The Dow jumped 936 points in one day. Over the course of the following week, the overnight LIBOR dropped back into more-or-less normal territory. Banks stopped collapsing. We have reached an island of, if not calm, at least diminished crisis.

A Status Report

In my next post, I’m going to talk about recent Obama administration initiatives and the future. But before I do, it may be useful to pause for a moment and assess where we are.

As I noted in my earlier post, some $500 billion of teaser-rate mortgages are still scheduled to reset over the next two years. Unless something is done, they will likely go into default. And those are only the US teasers; I have not found the corresponding data for the rest of the world.

Huge numbers of mortgages are already in default, many in foreclosure. The overhang of foreclosed homes continues to cause housing prices to fall. This, in turn, is causing other mortgages – including fixed-rate prime mortgages – to go into default. And the TARP has not yet bought a single mortgage or mortgage-backed security.

In the meantime, the LIBOR is back into normal territory. Apparently, banks are willing to trust each other. (Not surprising, given that governments are now guaranteeing all interbank debt.)

Unfortunately, this was not the most serious part of the liquidity problem. Recall that there were two problems. One was that banks weren’t willing to lend to each other. The other was that they weren’t willing to lend to anyone else. LIBOR only measures interbank lending, not lending to nonbank borrowers.

In fits and starts, the supply of commercial paper in the US now appears to be expanding. This means that lending to commercial borrowers is up. It’s not clear whether banks are doing the new lending or whether the new money is coming directly from the government. Either way, money is getting into the nonfinancial sectors. But it's still not getting to consumers.

Most importantly, it’s now clear that the liquidity freeze badly damaged real economic activity. Almost all recent news out of the real economy has been bad. Congress is currently worrying about whether to let GM, Ford, and Chrysler go bankrupt. If it does, studies suggest that the US unemployment rate will jump by about two percentage points, to well over 8%. On the other hand, even if the government bails US auto makers out temporarily, there’s no obvious reason to believe they will be financially viable in the long run.

So here's where we are: What began as a problem in the mortgage industry spread throughout the financial sector. This, in turn, produced a liquidity freeze. And the liquidity freeze, in turn, triggered a serious hit to real economic activity. Now the principal problem is the real economy.

Reports that former Sen. Tom Daschle will be appointed Secretary of Health and Human Services suggest that reform of the U.S. health insurance system will be an early priority of the next administration.

If so, then over the next six months, we should expect vigorous debate about the direction any such reform should take. Past debates on the topic have largely ignored a fundamental difference between individual and pooled coverage. Pundits and politicians often discuss the two approaches as if they are interchangeable. From an insurer’s perspective, however, they are profoundly different.

In an individual policy, the insured's financial health risks are transferred to the insurer. This has three major cost implications. First, insurers must charge a premium for assuming the risk, based on its probability and size. Second, before issuing an individual policy, the insurer must assess the risk it is assuming. Finally, the insurer must thereafter manage its risk – for example, by terminating ill policyholders, as some insurers have been doing here in California.

Individual policy premiums must cover these costs. If the insurer’s risk assessment is accurate, each policyholder's rates should reflect his or her individual financial health risks plus the costs of assessing and managing those risks; individual coverage should not ultimately shift costs among policyholders.

In pooled coverage, by contrast, financial health risks are shared among members of the pool. If the pool is large enough, the insurer bears very little of the risk. In consequence, competitive insurers should not charge significant risk premiums, no risk assessment costs should be incurred before a new member can be admitted, and risk management costs should be low. As a result, the costs of pooled coverage should, on average, be substantially lower than the costs of individual coverage.

Case in point: I am currently paying premiums on an individual policy for my healthy 23-year-old daughter. The monthly premiums for her individual policy are higher than those for the pooled coverage of all of the rest of my family put together – two 50-somethings and two risk-taking 6-year-olds. Same company. Identical coverage. Higher individual policy premiums for one healthy individual than for pooled coverage of four beneficiaries of mixed health.

Pooled coverage provides these cost benefits only if admission to the pool is not elective. Typically, we become eligible for employer-provided health insurance if and only if we work for that company. We can’t just opt in or out at will. Similarly, we become eligible for Medicare by getting older. The more elective admission to a pool becomes, the more the insurer must intervene to manage its risks and charge a premium for those risks.

So what does all this mean?

First, all else being equal, pooled coverage should always be cheaper than individual coverage. The non-health care costs of Medicare, for example, are only 3 percent, while the non-health care costs of private health insurance run between 30 percent and 35 percent.

This is not because government is more efficient. It's rather because private health insurers must charge risk premiums and recover risk assessment and management costs – no portion of which amounts go to pay for actual health care. Medicare avoids these costs simply by reason of the fact it provides the ultimate in pooled coverage.

In other words, because of the risk premium, assessment and management problem, it is inherently impossible to provide individual coverage at costs comparable to pooled coverage.

Second, because elective admission to a pool effectively converts pooled into individual coverage from an insurer’s perspective, free markets operating at the individual level cannot provide pooled coverage. If we give each individual $5,000, as Sen. McCain proposed to do, and let them comparison shop, competitive insurers will still have to charge risk premiums and recover their risk assessment and management costs.

In other words, unlike markets for spaghetti, jeans, or apartments, health insurance markets cannot find the lowest cost solution without government intervention.

The U.S. solution has been to create an $80 billion per year tax subsidy for employer-provided pooled coverage, Medicare pooled coverage directly for seniors, individual coverage for others who can afford it, and a hodgepodge of backup solutions (like emergency room care) for everyone else. The European solution, for the most part, has been to offer pooled coverage directly to everyone.

Because of the inherent cost advantages of pooled coverage, we should expect the European solution to be substantially cheaper for the same level of coverage. And indeed, on average Europeans pay a substantially lower percentage of GDP for a much higher level of coverage.

American conservatives are tempted to call this “socialism”, and I suspect we’ll hear that accusation a lot in the coming months. I like markets. If free markets could provide equivalent value more cheaply and efficiently, I might echo the conservative critique. But they can’t.

Any cost-effective proposal, therefore, is going to have to look more like Medicare than the competitive market in individual policies Sen. McCain was advocating during the recent presidential campaign.

This does not mean that any such proposal will need to limit a patient’s choice of doctors. Indeed, were I designing a new health care system, my sales slogan would probably be something like: “We pay, you choose.” Pooled coverage can be fully consistent with patient choice.

But to take advantage of the inherent cost benefits of pooled coverage, any such proposal will have to be mandatory and effectively universal. It may rely on a mix of government and employer funding. It may ask insurers to compete to insure mandatory pools at the lowest possible cost.

September 30, 2008

The ongoing turmoil in the financial markets has diverted me from my
usual tax academic pursuits, including this blog, for which I
apologize. This post explores the causes of that turmoil. My next post
will explore solutions currently under consideration, including aspects
of the so-called “$700 billion bailout.”

The current financial crisis has many causes, some long-term and
structural. I focus here, however, on three immediate aspects of the
crisis: the trigger, how problems generated by that trigger spread
through the markets, and how this produced the liquidity freeze that
persuaded Mr. Paulson and Mr. Bush to act (unsuccessfully thus far).

The Trigger: Teaser-Rate Mortgages

The media talks about “sub prime mortgages” – by which it means
mortgage loans to borrowers with less than stellar credit. The real
problem, however, was the advent and widespread use of teaser-rate
mortgages in both the prime and sub prime markets. A teaser-rate
mortgage allows a borrower to make relatively small payments for
several years. At some point, the rate jumps dramatically, and the
borrower faces much higher monthly payment obligations.

Not surprisingly, borrowers loved this innovation. Teaser-rate loans
allowed folks who otherwise could never have afforded to own a home to
buy one, at least until the rate reset. But it wasn’t just sub prime
borrowers who liked teasers. Teasers sold like hotcakes; loan
originators made correspondingly fabulous profits.

(Some have tried to blame teaser-rates on the Community Reinvestment
Act of 1977, which encouraged lending to minorities and lower income
Americans. But that act only applied to commercial banks. A majority of
this crisis’s teaser-rate loans were made by unregulated originators
not subject to the act. More fundamentally, there is no evidence the
present crisis started in 1977. Teaser-rate mortgages first became
widespread after Mr. Bush took office in 2001.)

In any event, it’s not hard to predict what happens when rates
reset. All of a sudden, buyers who have been paying $1,000 per month
face monthly payments of $4,000. Many, perhaps most, go into default.

The possibility that this would become a major problem became
apparent as early as 2005. (I actually wrote that fall predicting the
current crash.) Mortgage economists began publishing reset schedules –
schedules of how many billions or trillions of dollars of mortgages
would reset and when. In effect, those tables offered a rough schedule
of how many mortgages would go into default and when.

As defaults increased in number, lenders ended up holding large
amounts of foreclosed property. When they tried to convert the property
into cash, they put downward pressure on housing prices. And this, in
turn, made financing and refinancing more difficult and further
defaults more likely – even of non-teaser loans. (A perfect vicious
cycle, and we’re not remotely near the end of it. In parts of the
country, more half the homes offered for sale are now foreclosures.
Banks are desperate to get those homes off their balance sheets and are
dumping them much faster than the market can absorb them.)

The Spread: Securitization and Debt Chains

But why did Lehman Brothers and AIG go under? After all, they don’t make mortgage loans. I turn next to how the problem spread.

Assume that A borrows from B to buy a home, giving a mortgage on the
home to secure her debt. B then borrows from C, using A’s mortgage as
security. C in turn borrows from D, using B’s obligation as security.
And so on.

Now assume that A’s mortgage goes bad. What happens to B, C, and D? Answer: all the loans up the chain go bad as well.

And this isn’t all. If the loan is secured (as mortgages and many
other links in debt chains are), the lender is typically less
interested in the creditworthiness of the borrower. The lender relies
primarily on the collateral, not the borrower, for assurance of
repayment.

As a result, each financial intermediary can be thinly capitalized.
So a company with $10.1 billion in assets and $10 billion in debt may
have a small amount of net equity. Indeed, the more thinly capitalized
a company, the higher the return it can make on its capital.

Unfortunately, what this means is that when A’s mortgage goes bad,
it’s not just the loans up the chain that go bad – financial
intermediaries in the chain often go bust as well. A thinly capitalized
intermediary cannot absorb many losses. And that is why teaser-rate
mortgage defaults triggered and are still triggering defaults and
failures across the entire financial sector. Almost everyone was in the
debt-chain business and extended themselves to the max to take
advantage of the extraordinary profit opportunities of that business.

I’ve explained the transmission mechanism in terms of debt because
readers have an intuitive understanding of how debt works. In fact,
however, many of the most important links in the chain were not
technically “debt.” Some were shares in “mortgage pools”; some,
“derivatives”; some, “credit default swaps.” What they all had in
common was that each transferred some risk of default up the chain to
someone else. Wall Street sometimes calls links in such debt chains
“toxic waste,” because today no one wants them.

AIG, for example, held about $500 billion in “notional exposure” on
credit default swaps. In English, it was at risk to the tune of about
$500 billion if mortgages down the chain went bad. When mortgages began
to go bad in large numbers, the market realized that AIG might not be
able to cover its obligations and began to sell AIG stock seriously
short. Lenders stopped lending. End of story.

What made this more than just a corporate problem was that AIG was a
domino at the head of many long chains of dominoes. If AIG had gone,
some believed the world would have faced immediate economic collapse.
So the US government bought an 80% stake in AIG in exchange for enough
money to allow AIG to dissolve gracefully – over a couple of years –
instead of imploding overnight.

The Crisis: Liquidity Freeze

None of this, however, would by itself have led a free-market US
administration to propose a $700 billion general “bail-out.” Real
estate is important, yes, but there are many parts of the economy not
dependent on the market for home mortgages. What happened?

In ordinary times, most businesses borrow on a short term basis to
fund payroll, inventory, and other operating needs. There are two
principal sources of short-term money: banks and money-market funds. In
the past several weeks, each of these has substantially reduced the
amounts they are willing to lend. This is what’s called a liquidity or
credit freeze.

Why did banks and money-market funds stop lending?

Let’s start with money-market funds. Investors put money into
money-market funds when they want absolute safety and the ability to
pull their money out at will. Put in a dollar, get out a dollar,
whenever you want. In return, they accept a very low return. What
happened was that The Reserve, the oldest and most highly regarded
money-market fund sponsor, “broke a buck” – which means it paid back
only 97 cents for every dollar investors put in.

The reason was simple: The Reserve had loaned short-term money to
Lehman Brothers, a major participant in the debt chain business. Lehman
Brothers went belly up, and The Reserve’s short-term loans to Lehman
became uncollectible. (Remember that the Treasury and the Federal
Reserve Bank, having bailed out Bear Stearns, decided to let Lehman
Brothers go bankrupt to teach the market a lesson. In retrospect, this
was probably a mistake.)

As a result, investor confidence in money-market funds plummeted.
Fortunately or unfortunately, investors always have a secure place to
park money, Treasury bills – short term obligations issued by the U.S.
government. When The Reserve broke a buck, everyone moved their money
into Treasuries. Money-market funds dried up. And that was the end of
one major source of business working capital.

Another major source is the banking system. Unfortunately, banks and
other financial intermediaries became reluctant to loan to each other.
As a result, money in one part of the banking system stopped flowing to
where it was most needed.

Why did banks stop loaning money to each other? When lenders lend,
they generally look at borrowers’ financial sheets to determine how
creditworthy they are before giving out money. Unfortunately, most
banks and other financial intermediaries have large amounts of toxic
waste on their books.

In situations like this, accounting rules require companies to “mark
assets to market.” If an asset with a face value of $100 appears to
have a market value of $40, the company is supposed to record a loss of
$60 immediately, even before the asset is sold, and to carry that asset
on its books at a value of $40. So banks and other financial
intermediaries began reporting enormous losses on the toxic waste they
held, and their balance sheets crumbled. (The head of
the Securities and Exchange Commission was pressured to waive this
rule, but refused. It was for this reason that Sen. John McCain
demanded that he be fired.)

But recognizing market losses isn’t the most serious
problem. If a lender can be confident that the asset in question really
has a value of $40, it may still conclude that the prospective borrower
is likely to repay the loan – notwithstanding the reported loss. If no
one knows how much the toxic waste is actually worth, however, lenders
can’t assess the creditworthiness of any prospective borrower with
significant amounts of toxic waste on its books. Almost all banks hold
toxic waste. So banks stopped lending to other banks. (Waiving the
mark-to-market rule would not have solved this problem; it would
simply have hidden the accrued losses. Banks are sophisticated enough
to worry when accounting rules do not correctly reflect what's going on
in the market.)

But why is the unavailability of short-term money so bad?

Remember what businesses use short-term money for – to meet payroll
and put inventory on their shelves. When businesses lose access to
working capital, they stop operating, not because there is anything
fundamentally wrong with their products or markets or business plans,
but simply because they can’t get the cash they need on a daily basis.

You might think of short-term money as the lubricant that keeps the
world’s economic engine turning over smoothly. If there’s no lubricant,
the engine freezes. No paydays, no goods on the shelves. Seriously.

This was the possibility that persuaded Mr. Bush and Mr. Paulson to
change course and support a general “bail-out.” And it remains a very
real possibility.

The $700 Billion Bailout

I will discuss the details of possible solutions in my next post.

What is important to emphasize here is that current proposals are
primarily intended to solve the liquidity freeze part of the problem –
to prevent the world’s economic engine from seizing up.

Mr. Paulson’s original proposal hoped to accomplish this in two
ways. First, by buying up toxic waste at fair market value, Mr. Paulson
could take toxic waste off financial intermediaries’ balance sheets.
This would allow lenders to assess borrowers’ creditworthiness with
greater confidence and, hopefully, get banks to start lending to each
other again.

Equally importantly, however, Mr. Paulson requested authority to buy
up that waste at whatever price he thought best. By buying toxic waste
at higher prices than private buyers were willing to pay, he hoped to
bolster the financial intermediaries’ balance sheets – to make them
more creditworthy.

This aspect of the proposal was what made it a “bail-out.” And this was part of what led to its defeat in the House.

Note that Mr. Paulson’s proposal was not intended to solve the
teaser-rate mortgage problem, either now or in the future. In the
transactions that created the teaser-rate mortgages in the first place,
both parties made bad decisions – the lender and the borrower. Mr.
Paulson’s proposal was not intended to help either. One of its
unavoidable side effects, however, was to relieve lenders of the
consequences of their bad decisions, while leaving borrowers to suffer
the consequences of theirs. This made it politically less palatable.

In addition, at least $500 billion more of teaser-rate mortgages are
scheduled to reset over the next several years. In all likelihood, they
too will go into default and become toxic waste. Nothing in Mr.
Paulson’s original proposal was intended to do anything about this next
$500 billion installment – or, indeed, to prevent lenders from making
more teaser-rate mortgages in the future.

Similarly, Mr. Paulson’s proposal was not intended as a general Wall
Street bail-out, although to some extent it would have had that effect.
Note that the outstanding overhang of credit default swaps alone is
estimated to be between $45 and $60 trillion – three to four
times the size of our annual gross domestic product. The requested $700
billion, although the single biggest appropriation request in U.S.
history, was miniscule when compared with the toxic waste problem as a
whole. Mr. Paulson’s proposed solution was to cost just 1% of the size
of the problem and was aimed only at a small part of that problem. (It
is unnerving to realize that the U.S. government – the “beast” we have
been starving for so long – may now lack the borrowing capacity to
solve the problem as a whole. We need to get our financial house in
order.)

All Mr. Paulson’s proposal aimed to do was to put lubricant back
into the engine, to get short-term money flowing again to prevent our
economic engine from freezing up. Now that the proposal has gone down
to defeat, we can only hope that Mr. Paulson was wrong.

August 18, 2008

Economists assume that US jobs move elsewhere because costs are lower elsewhere. Sometimes this is true, sometimes not.

What few understand is that our own Internal Revenue Code, in interaction with other countries' tax systems, actually encourages businesses to move American jobs to other countries.

Bear with me. This is a little complicated. But it’s really important.

The problem is most easily explained by comparing our income tax with a water’s-edge value-added tax (or “VAT”). A VAT is simply a tax on the value each business adds to the economy, regardless of whether it makes or loses money. Almost every developed country except the US uses a VAT.

So what’s the problem? When you fight through the details, ultimately our system taxes by place of business activity, both production and sales. A water’s-edge VAT, by contrast, taxes by place of sales.

Why is this a problem?

Put yourself in the shoes of a business trying to decide where to locate its plant and jobs – the US or Country A. Country A, let’s assume, uses a VAT.

If our hypothetical business locates in the US to sell into the US, all of its profits will be subject to US income tax. If it locates in Country A to sell into the US, it will pay will pay US income tax only on the portion of its profits attributable to sales and no VAT to Country A. (Remember, a VAT taxes by place of sales.)

Where to locate, all else being equal? Country A, obviously.

What if it plans to sell into Country A? If it locates its plant and jobs in Country A, it will pay full VAT on its sales. If it locates in the United States, it will pay the same full VAT to Country A plus US income taxes on profits attributable to its production activities.

Where to locate? Again, Country A.

Not all countries use VATs. Some use income taxes or a mix of income taxes and VATs.

Comparing income taxes is more complex because income taxes are more complicated and vary more widely. But there are ways to make an income tax system effectively tax by place of sale. If our competitors do so and we do not, businesses face the same incentives to move jobs elsewhere that I’ve described above with respect to a VAT.

Even if a competitor’s income tax system looks exactly like ours, a competitor that raises half its revenue from a water’s-edge VAT and half from a US-style income tax still gives multinational businesses significant reason to locate jobs and plant there, not here.

At this point, you may be wondering why our government does this to us. The answer is that, for the most part, it doesn’t yet understand what I’ve just told you.

Back before NAFTA, GATT and free trade, the problems I’ve described didn’t matter. If you wanted to sell into the United States, you produced in the United States. If you didn’t, you faced major customs duties.

When the US joined the free trade movement, however, it neglected to think about whether the tax system it had been using for the better part of a century was up to the challenge. Our system is so complex that even experts sometimes have a hard time seeing the forest for the trees. (It took me a quarter century of working and teaching in the area to figure things out.)

A further part of the problem is that those who understand our international tax system best have a vested interest in keeping it around. Every multinational has decided where to locate its productive capacity based on existing subsidies. If we were to level the playing field, they’d have to move jobs back here. Moving jobs costs money. They'd also have to give up the tax breaks they now get for moving jobs out of the US.

As a result, I’m one of very few people pushing this issue. (Obama has now promised to fix the problem. So far, McCain is sticking with the status quo.)

But the bottom line is still the bottom line. Our tax system, in interaction with the systems of other countries, gives tax breaks to businesses that move jobs and plant out of the US.

July 29, 2008

One of the least understood but most important concepts in tax is “incidence.”

If we impose a tax on A, it may be that A can pass the cost on to B. B may then be able to pass that cost on the C. And C may not be able to pass it on to anyone else. If so, we say that the “incidence” of the tax falls on C.

What this means is that A, nominally subject to the tax, may not ultimately bear the burden of the tax at all.

In 1990, for example, Congress enacted a 10% tax on luxury items – luxury cars, yachts, private planes, jewelry, and furs. The idea was to tax the “rich” without increasing top income tax rates.

What happened instead was that demand for items subject to the tax – yachts, for example – went down. To continue selling yachts, therefore, yachtmakers had to cut prices. In other words, they had to eat the tax.
Yachtmakers, in turn, responded by cutting wages. It turned out that luxury yachts were generally made in small towns without employment alternatives. So when yachtmakers cut wages, workers had no other place to go. They had to accept the pay cuts.

Bottom line: the cost of this so-called “luxury” tax ended up being borne primarily by low-income workers.

The incidence of a tax depends on the alternatives the various players have. The player with the fewest choices generally bears the incidence of the tax.

The “rich,” it turns out, can do without yachts. Yachtmakers, on the other hand, cannot do without customers. And yachtmakers’ workers have no choices at all.

This is why taxes on individual income make at least some sense. If an income tax is well-structured (admittedly a big if), to avoid the tax you have to do without income. Most folks like income. And therefore most folks end up bearing the share of the income tax nominally imposed on them. They generally can’t pass it on to someone else.

(This is not always true of businesses, but that’s a topic that merits its own discussion.)

In my next post, I will apply the concept of incidence to other types of government action – tax “cuts,” for example. It turns out that a tax “cut” for A may create costs for B. In effect, B bears the cost of the tax “cut.” From a devious politician’s perspective, the wonderful thing is that B has no clue. From an honest politician’s perspective, the problem is that Congress often has no clue either.

July 10, 2008

Taxes are the dues we pay to belong to Club USA. The Club provides enormous benefits to its members – safety, prosperity, freedom, security, community. It charges dues on a sliding scale, based on its members’ ability to pay. April 15 is Dues Day.

Some say taxes are theft. I say that taking Club benefits without paying dues is theft.

Some say they would like to starve the Club to death – “to get it down to the size where we can drown it in the bathtub.” I say that folks who don’t like our Club should join a different one.

I’m tired of paying my Club dues regularly and honestly and listening to freeloaders who shave their taxes run the Club down on talk radio while expecting the Club to bail them out whenever they’re in trouble.

Honest taxpayers are the true silent majority. It’s time for us to speak up.

July 01, 2008

U.S. oil companies are pushing hard to get Congress to allow the current Administration to issue more oil leases before its term expires. In response, skeptics have noted that three-quarters of the 90 million-plus acres of federal land already leased for oil drilling are not being worked. Oil companies deny this. Regardless of who is right, the number of operating oil rigs in North America declined across the course of 2007.

In the meantime, OPEC has raised its quotas by only 20% since 1998 – a measly 2% per year. World GDP grew by about 85% over the same period. The International Energy Agency reports that non-OPEC oil countries are also underproducing and predicts that they will continue to do so.

Everyone seems to be holding back.

Why?

The most likely answer is very simple.

Goldman Sachs has predicted that the price of oil may move past $200/barrel within the next 6 to 24 months. OPEC's chief and EU’s energy commissioner have also both warned that prices in excess of $200/barrel are possible in the near future.

Suppose you owned a source of oil. Would you sell that oil now for $140/barrel? Or would you wait for two years and sell it for $200/barrel?

Obviously, you would wait.

Nor is it clear that oil prices will peak at $200/barrel. If world GDP rises another 85% over the next decade and oil production increases by only 20%, we may come to view $200/barrel oil as dirt cheap.

So what to do?

On the tax side, Congress has done almost all it can do to stimulate U.S. production.

A 2005 Congressional Budget Office study concluded that the effective 2002 U.S. tax rate on profits from petroleum and natural gas structures was the lowest imposed on any type of corporate capital asset: 9.2%. Profits from computers, by contrast, were taxed at an effective rate of 36.9%.

If tax incentives were going to induce U.S. oil companies to drill, they probably would have done so by now. Interestingly, Sen. McCain and Sen. Obama both propose to eliminate oil production tax incentives. After all, if oil companies are not responding by increasing production, those breaks are just gifts from you and me to Exxon.

Perhaps there is another question we should be asking: Are the oil companies right?

Remember that prices are a measure of value. If oil prices are going to be much higher 10 years from now, that means oil will be more valuable then than it is now. Valuable to us.

If so, should it really be our policy to drain U.S. reserves as quickly as possible? Or should our policy be to save at least some of those reserves for the day when gas is $10/gallon?